The ongoing bull market in commodities has coincided with the introduction of many new CFDs in recent years that replicate the underlying action in various base and precious metals, energy issues and other markets that were previously available only through the futures market. With ongoing demand for commodities from the Far East coupled with a reduction in long term supply because of a lack of investment in many areas, there is clearly scope for significant future gains in this sector. As with stock indices, a good way of judging the overall trends within commodities is to examine the CRB index, which is featured alongside crude oil and gold within each days morning report from Blue Index.
The idea of a daily commodity price index goes back to 1934, when the US Bureau of Labor Statistics began to calculate an index based on quotations for sensitive commodities. After being released to the general public in January 1940, twelve years later a new Daily Index of Spot Market Prices was introduced, based on 22 commodities. The index was rebased twice, in 1962 and 1971, and then produced once a week until May 1981 when Commodity Research Bureau (CRB) began calculating the index on a daily basis. It currently has 17 constituents.
The idea is to measure price movements of basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. As with other indices, the CRB is modified regularly, and as an example the original index included lard and onions, but did not include crude oil or gold, as it does now.
The constituents are as follows:
It is beyond the scope of this article to analyse which actual contracts are used for each commodity, as that process is fairly complex and relates to the number and timing of the respective contract series traded. But once a current valuation is achieved for each, the index is calculated.
Historically, the index was calculated geometrically, with the 17 component commodities each responsible for about 5.9% of the indexs weight. Each day that the seventeen values were multiplied and the 17th root of this figure then taken. As with other indices, once this figure was achieved it was given a base valuation (100 in this case) as a divisor, and that gave the CRB index which now stands at 317 or thereabouts.
As the original CRB index was equally weighted and geometrically averaged it had a high level of smoothing, so that the index was not unduly influenced by volatility in any one commodity. Also, individual commodity prices were averaged across their various futures contracts expiring in the next six months to further smooth out the index. In July 2005, however, the CRB was revised and the contracts were calculated differently, but most importantly it was weighted due to the perceived importance of each commodity, in the same way as the FTSE 100 index is calculated fro instance. The thinking was that crude oil in particular should not be weighted to the same value as say orange juice, which is sensible.
There was another reason for this and that was the desire to make the index more volatile for speculators in the new CRB futures market that was created on that revision, and this makes it much more relevant for technical analysis. A further change was that while it was geometrically averaged, the CRB was effectively continuously rebalanced and a rising commodity price would get less exposure while a falling one would get more exposure in influencing the final index number, and this was also eliminated.
The biggest weighting now is crude oil at 23% of the CRB index, and total petroleum products have a weight of 33%, which also include unleaded gasoline. When natural gas is included, the energy exposure rises is up to 39%, and this reflects how much this commodity group is involved in the economy. The other side of this weighting change is that grains, meats, tropicals (sugar, cotton, coffee, cocoa, and orange juice) and metals have been reduced, which again reflects that the costs of these commodities are usually small relative to the total dollars an average first-world consumer spends on commodities in a typical year. Gold, which is an important CFD trading issue, has a weighting of 6.0%, for example.
So, the bottom line is that the CRB is almost one-quarter constituted by oil alone, and this would explain why the index has edged up slightly over the last month despite the tremendous rise in copper, nickel and various softs.
A final point – inflation
Many commentators have pointed out recently that with the CRB index last year hitting new highs for the first time in two decades, there is now not so much scope for gains in commodities, and the best of the rises have already been seen, but there are two points to make here.
First, the breaking of a previous important high level for the first time is usually a very bullish event, and if those highs can be held on any pullback it creates a tremendous level of potential support in the future. Also in terms of commodities, bull and bear markets run for much longer lengths than stocks, because there is a naturally longer business cycle in place, typically between 10 and 20 years, as opposed to the classical four year share price cycle. Commodities as a group have been in a bull market for four years, which can be considered just the beginning if the cycle unfolds to the seventeen years seen in the last bull market.
Second, and because of the length of these timelines, inflation comes into play. Whilst in nominal terms the CRB looks close to previous highs, in real terms the index would have to rise to over 1000 to match previous peaks. We have often mentioned that oil and gold are significantly down in real terms over the last two decades, so when you read of $150 a barrel oil and $2000 an ounce gold in the future, it may not be so far fetched as it seems. This is food for thought for CFD traders who now have easy access to these exciting and volatile markets.